Firms» risk management practices

7 Systemic vs. marginal risk Prudential regulation of banks has previously focused more on the risk of individual financial institutions VaR to determine capital requirements VaR of an institution measures ≈how much the institution can be harmed by market moves∆ It is concerned with the marginal loss distribution of the institution∑Ãs portfolio On the contrary, systemic risk in the financial system is concerned with ≈how much the financial system can be harmed by the failure of the institution∆ It is concerned with the joint distribution of the losses of all market partici- pants and requires modeling financial linkages and how losses are transmit- ted through the financial system DIRECTION DE LA STABILITE FINANCIERE 8 How to assess systemic linkages? Methodologies include: Key advantages : analysis of linkages allows to: DIRECTION DE LA STABILITE FINANCIERE Those that rely primarily on institutional data, such as network analysis - identify both potentially systemic and vulnerable institutions, - track potential contagion path. Key drawbacks : - hard to get comprehensive information at an institutional level, - existing literature does not model endogenous response of institutions to shocks. And those that draw inference from market data, such as co-risk analysis - Key advantages: can be carried out with public data. - Key drawback: Uncertain forecasting performance + lack of ≈structural∆ underpinnings. 9 Network analysis DIRECTION DE LA STABILITE FINANCIERE 10 Network analysis DIRECTION DE LA STABILITE FINANCIERE The regulator will be able to compute such measures of systemic risk impact if institutions are required to disclose, not only an aggregate risk figure such as VaR, but also their risk exposures above a given threshold to all counterparties. This will enable the regulator to map the counterparty network Co-risk Analysis Capturefinancial institutions» co-dependence risk arising from direct and indirect linkages from publicly available data. Indirect linkages arise from exposure to common risk factors such as reliance on wholesale funding markets, similar portfolios, and so on. Thus, this work can complement network analysis. Under efficient markets, pricing of indirect linkages should result in co-move- ments of institutions» equity prices and credit risk measures, such as CDS spreads, Moody»s KMV Expected Default Frequencies, Bond Spreads. Nodes are scaled by Total External Assets + Total External Liabilities for each node, and links between nodes i and j by Total External Assetsij + Total External Liabilitiesij GDPi+ GDPj . The data are developed and analyzed in Kubulec and Sa 2008.